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Debt can often be a thorn in your side on the path to building wealth, but it’s not all bad.
Still, if you’re a homeowner with a mortgage, you’ve likely weighed the decision to pay it off early, if you can afford to. It’s a worthy goal to be free and clear of all debt, but is it the right choice if you’re trying to optimize your every dollar?
We consulted Brian Fry, a certified financial planner who founded Safe Landing Financial. He said the answer really depends on the specifics of the situation, but generally the biggest factor in deciding whether to pay off a mortgage early or invest your extra cash from a windfall, salary raise, or some other source is the interest rate.
Here are his high-level recommendations. Scroll down for the full set of assumptions he used.
If the rate on your mortgage is higher than what you might make by investing the cash, it’s often better to pay down your debt before investing more, Fry said.
That is, unless you consider refinancing to secure a lower rate, he said. In fact, refinancing can be a good option whether or not you ultimately decide to pay your mortgage aggressively. Interest rates fluctuate and they’re currently at historic lows, so be sure you shop around before making a decision or running your own numbers.
But Fry said it’s also crucial to look at how far you are from retirement, how long you plan to stay in the home, whether you have other high-interest debt, the possibility of tax deductions, and the status of your emergency fund and retirement savings. There are non-financial factors to think about as well.
“It’s really important to have a good understanding of what you’re trying to accomplish before determining the best course of action,” he said. And if you need help, a fee-only financial planner can be a great resource, he said.
To help illustrate the debate between paying off your mortgage early versus investing, we asked Fry to run a simulation. Below are the assumptions he used:
A homeowner just got a raise that will net them an additional $24,000 a year after taxes. They plan to stay at this job, and it’s unlikely they’ll get any more raises or cost-of-living adjustments. (This figure was used for the purposes of this calculation; a smaller raise or windfall would yield similar results.)
They have an established emergency fund and no other debt, and they’re already maxing out their 401(k) and IRA. They plan to stay in their home forever and retire in 15 years, at 65.
Their initial mortgage balance was $400,000 on a 30-year fixed-rate loan they got in 2006 with an interest rate of 6.15%. They are 15 years into their mortgage and have a remaining balance of $285,058.
If they refinance to a 15-year fixed mortgage, their interest rate would be 2.60%. Refinancing costs are estimated to be $6,000, for simplicity. Generally, refinancing costs are 1.5% to 4% of the remaining mortgage balance.
Their nest egg is diversified, and they are looking to make the best financial decision about how to use the extra income to maximize their wealth. Do they use this extra money to pay off their mortgage more aggressively, or invest more aggressively?
Fry used Right Capital, a financial-planning software, to calculate how much the homeowner would have in a taxable investment account in 15 years using a straight-line analysis.
The variables are whether they refinance their mortgage, and whether they put their additional income (and savings from refinancing, if available) into an investment fund or put it toward their loan balance.
Fry used the Vanguard Total Stock Market Index Fund, which has a long-term annual return of 5.38%, according to JPMorgan estimates. He said it’s important to remember that the market doesn’t go up by the same percentage every year: Some years offer better returns, while others may have negative returns.
Invest more aggressively:
Pay mortgage more aggressively:
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